World View & Market Commentary. Forest first; Trees second. Focused on Real & Knowable facts that filter through the "experts" fluff and media hyperbole. Where we've been, what the future may hold and developing a better way forward.

Friday, August 21, 2009

For capital to form and concentrate IN A HEALTHY MANNER, the rule of law must be spelled out AND FOLLOWED. If the rules change over time, then those who have capital will look elsewhere to put their money to work.

One bad example would be Hugo Chavez in Venezuela who just up and decided to nationalize the oil industry there… then the mines… then the telecommunications… then the utilities… then the_____, and so on. I can’t think of a better way to drive away capital, can you? A person would be nuts to do business in that environment.

People forget that China is still a communist country – central planning and CONTROL. Sure, they are “embracing” some free market principles in an attempt to draw in capital to produce employment, but the rule of law is not really settled there, is it?

-Laws should be stable and not changed too frequently, as lack of awareness of the law -prevents one from being guided by it.

-There should be clear rules and procedures for making laws.

-The independence of the judiciary has to be guaranteed.

-The principles of natural justice should be observed, particularly those concerning the right to a fair hearing.

-The courts should have the power of judicial review over the way in which the other principles are implemented.

-The courts should be accessible; no man may be denied justice.

-The discretion of law enforcement and crime prevention agencies should not be allowed to pervert the law.

I would contend that some of these rules are slipping right here at home, such as the “independence of the judiciary.”

The rule of law is what led the world out of the dark ages. The concepts began to form about that time and really solidified with the signing of the Magna Carta, a document that underpins our own founding papers. But the rule of law really took shape in regards to the economy and how it allowed capital to form and concentrate in the 17th century as described by Wikipedia:

...two of the first modern authors to give the principle theoretical foundations were Samuel Rutherford in Lex, Rex (1644) and John Locke in his Second Treatise of Government (1690). Later, the principle was further entrenched by Montesquieu in The Spirit of the Laws (1748).

In 1776, the notion that no one is above the law was popular during the founding of the United States, for example in the pamphlet Common Sense by Thomas Paine: "in America, the law is King. For as in absolute governments the king is law, so in free countries the law ought to be king; and there ought to be no other." In 1780, John Adams enshrined this principle in the Massachusetts Constitution by seeking to establish "a government of laws and not of men."

I would contend that capital forming and concentrating is a great thing – it has advanced the human race and without it exploration and stunning new technologies would not be possible. BUT, it definitely can be overdone – as with most things in life there is a balance. When capital becomes too concentrated in the hands of just a few, bad things tend to happen after greed takes over.

That’s why the original intent behind corporations was a good one. Limited liability allowed capital to concentrate. But once concentrated, WHO decides where and how it should be put to work? That’s where governments who get too involved get in and muck up the works as they are terrible at choosing the areas where capital would best benefit society. I know that sounds terrible because that’s pretty much what you “elect” your representatives to do. In the United States corporations have become so powerful that they tell your representatives what to do or else they will not get the money to get reelected.

That’s how capital becomes misallocated in this country. It’s concentrating all right, but it’s concentrating in all the wrong places – the central banks.

Here’s a PATRIOT who understand this basic premise and gave Nancy Pelosi a serious piece of his mind!

BRAVO! And well deserved I might add. However, Mr. Guthrie, like most good Americans, still has not figured out that the wars he and his son so bravely fought, were wars designed and extended by the manufacturers of the fractional reserve, interest bearing, fiat money system - you know, the purveyors of debt! “Credit” equals debt, DEBT equals control. These are the same people who manufacture the weapons of war, and now the same people who control the media and the other three branches of government – you know, the executive, legislative, and judicial. What, you call that a conspiracy? I don’t, I call it fact, and I call it concentration of capital taken to an extreme.

So, what’s all this have to do with China?

What really got me thinking about this piece was the following article:

Aug. 21 (Bloomberg) -- China plans to tighten capital requirements for banks, threatening to curb the record lending that’s fueled a 60 percent rally in the nation’s stock market, three people familiar with the matter said.

The China Banking Regulatory Commission sent draft rule changes to banks on Aug. 19 requiring them to deduct all existing holdings of subordinated and hybrid debt sold by other lenders from supplementary capital, said the people, who have seen the document. Banks have until Aug. 25 to give feedback, said the people, declining to be named as the matter is private.

As a result, banks may need to rein in lending or sell shares to lift capital adequacy ratios to the 12 percent minimum. Chinese stocks briefly entered a so-called bear market this week on concern the government would stymie new loans that exceeded $1 trillion in the first half. A news department official at the regulator declined to comment by phone and didn’t immediately respond to a faxed inquiry.

“This move will cut one of the most important funding sources for banks,” said Sheng Nan, an analyst at UOB Kayhian Investment Co. in Shanghai. Banks will “have to either raise more equity capital or slow down lending and other capital consuming businesses to stay afloat.”

Hong Kong’s Hang Seng Index slid 0.6 percent at the 4:00 p.m. close, after having risen as much as 0.5 percent. China’s benchmark Shanghai Composite Index rose 1.7 percent to close at 2960.77, paring earlier gains of as much as 2 percent.

Debt Sales Triple

China’s banks have sold 236.7 billion yuan ($34.6 billion) of subordinated bonds so far this year, almost triple the amount issued during all of 2008. The banking regulator estimates about half of the subordinated bonds in circulation are cross-held among banks.“We understand the regulator’s concerns about the proportion of subordinated debt,” Shenzhen Development Bank Co. Chairman Frank Newman said on an earnings conference call today. The bank hopes that any new rules are applied only to future debt sales, Newman said.

The subordinated debt sales came as new loans rose to a record 7.37 trillion yuan in the first half. Lending in July fell to less than a quarter of June’s level. About 1.16 trillion yuan of loans were invested in stocks in the first five months of this year, China Business News reported on June 29, citing Wei Jianing, a deputy director at the Development and Research Center under the State Council, China’s cabinet.

Cheap Money

“I’m worried about a correction in a market that has been driven by cheap money,” Devan Kaloo, who oversees $11.5 billion as head of global emerging markets at Aberdeen Asset Management Ltd., said Aug. 19.

The Shanghai Composite Index almost doubled during the first seven months of this year through Aug. 4, after falling 65 percent in 2008. Since reaching this year’s high on Aug. 4, it’s plummeted 15 percent. The index on Aug. 19 briefly fell 20 percent from this year’s high, the threshold for a bear market, before ending the day down 19.8 percent. The gauge rebounded yesterday, rising 4.5 percent.

Regulatory Concern

The banking regulator has indicated it’s concerned about excessive credit creation. Last month, the commission ordered lenders to raise reserves against non-performing loans, to ensure loans for fixed asset investments go to projects that support the real economy and announced plans to tighten rules on working capital loans.

Banks are allowed to count subordinated bonds they sell as supplementary or lower-Tier 2 capital. In the event of bankruptcy, holders of subordinated notes receive payment only after other debt claims are paid in full.

The regulator’s rule change requires banks to subtract all existing holdings of subordinate bonds issued by other lenders from their own subordinated bonds being counted as supplementary capital. The Wall Street Journal and Reuters reported earlier that the regulator was considering this measure.

In addition, the new rules also limit the amount of subordinated or hybrid bonds banks can hold, the people said. A bank’s holding of subordinated and hybrid bonds issued by a single bank can’t exceed 15 percent of its core capital, the people said. Holdings of all subordinate and hybrid bonds issued by banks can’t exceed 20 percent of core capital.

Capital Adequacy

The regulator has called on small publicly traded banks to have a minimum capital adequacy ratio of 12 percent by year’s end, up from the current 10 percent. The ratio, a measure of how much in losses a bank can absorb, is calculated by dividing capital by risk-weighted assets. A bank’s risk-weighted assets are comprised partly of loans.

After deducting subordinated bonds issued by other banks, lenders must either raise core capital or reduce their loans to meet the capital adequacy ratio requirements.

“It’ll be hard for commercial banks to sell subordinate bonds because much of the debt is sold to their counterparts,” said Xu Xiaoqing, a bond analyst at China International Capital Corp. in Beijing. “This rule would tighten lending by commercial banks, especially small and medium sized banks that have relatively less capital.”

So, let’s review the past… a huge stock market bubble was blown in China, a result of a massive world wide credit bubble started by the geniuses on Wall Street who managed to end Glass-Steagall and create the unregulated and untracked shadow banking system that was behind all the financial bubbles. China just happened to be seduced by all the cheap and easy money and opened themselves up to it.

Later, long after it was painfully obvious that their entire markets were fueled by speculation and hot money, the central planners of China intentionally pricked their bubble by repeatedly raising capital requirements.

Then, seeing the aftermath of a popped bubble, they loosened everything up again and now, surprise, they have fueled a massive reflexive bounce…

Only to prick it again and to reenter another bear market. We would never do anything like that would we, because we are WAY different than China, right?

Oops.

I mean after all, we’ve neeever seen anything like that in history before, have we?

NASDAQ

Oops.

WILD GYRATIONS are caused by economic “pilots” who make their inputs out of synch with the economy – in the world of airplanes these are called Pilot Induced Oscillations (PIO). The problem with PIO is that if you let it go too far, eventually the wings will literally break off. That’s what China is doing, and that’s what we’re doing. What we’re NOT doing is keeping the swings small by letting FREE MARKET FORCES correct the gyrations early.

But here’s another clue for all the central bankers of the world… free market forces will only dampen out the cycles naturally when the system is built with DYNAMIC STABILITY to begin with.

DYNAMIC STABILITY is the tendency that once the current state is “upset” that it tends to dampen and return to neutral ON ITS OWN.

Dynamic Stability:

This contrasts with Dynamic INstability which, when upset, will tend to DIVERGE from neutral, producing larger and more violent swings.

Dynamic Instability:

Interest Bearing Fractional Reserve Money by Fiat is NOT built with dynamic stability in mind. It is built with never ending growth via inflation in mind, because that’s how the people who produce it (central banks) make their riches. Never ending growth leads to exponential math which produces a parabolic curve that ends in a blow-off top and then collapse.

And here’s the thing about stability… it’s always a tradeoff. The jet fighter trades stability for maneuverability. The same is true for the Corvette. Your family mini-van, however, is built to be stable and not too maneuverable.

So why was our money system “designed” to be inherently “unstable?”

Here’s an observation that may help you answer the “why…” Those who are closest to inflation gain, while those being whipped at the opposite end of inflation lose.

I’d call those at the end of the inflation “whipping boys,” they are also known as the “sheeple.” Or, they are also known as you and me!

China = Central Planners? America = Central Bankers!

Speaking of wild gyrations… They are the “hound dogs” and they ain’t no friends of mine.

Well they said you was high-classedWell, that was just a lieYeah they said you was high-classedWell, that was just a lieWell, you ain't never caught a rabbitAnd you ain't no friend of mine